Israel has been accused of violating the US-sponsored "road map to peace" after announcing its intention to build 3,500 new homes for Jewish settlers on Palestinian territory.
The road map requires an end to settlement expansion in the West Bank and Gaza Strip, seized by Israel in the 1967 Middle East war.
However, US President George W. Bush said in 2004 that Israel, which is planning a partial withdrawal from Gaza and the West Bank, could expect to keep some West Bank settlement blocs under a final peace agreement.
Nevertheless, Mr Bush also expressed support for establishment of a Palestinian state that is viable and contiguous.
Israel claims the whole of Jerusalem as its undivided capital, a claim that is not recognised internationally.
The Palestinians, who want East Jerusalem as the capital of a future state, have accused Israel of poor faith in peacemaking.
"By expanding settlements in the West Bank, Israel gives the impression that it intends to exchange Gaza for a 'Greater Israel'," said Palestinian Planning Minister Ghassan al-Khatib.
"Israel is responsible for any consequences resulting from this continuous violation of the road map," he said. "I don't think the Palestinian leadership and people can tolerate this."
Asked about the new project, a US official said: "We expect Israel to abide by its commitments under the road map."
Israeli prime minister Ariel Sharon has also ordered a new highway to bypass the area and link the Palestinian-ruled cities to the north and south of Jerusalem, Ramallah and Bethlehem, according to Israeli government sources.